In response to a record number of pending “inversion” transactions and the perceived potential loss of tax revenue, the U.S. Treasury Department (Treasury), on September 22, 2014, issued Notice 2014-52 (the Notice), announcing and detailing to-be-issued regulations intended to (i) make it more difficult to accomplish an inversion, and (ii) reduce the perceived tax advantages of doing so with respect to the untaxed earnings of foreign subsidiaries.
The Notice (and upcoming further guidance from Treasury in this area) is expected to have a significant impact on companies planning an inversion (or party to a pending inversion transaction), but the full impact– including on foreign-based multinationals having U.S. subsidiaries –is not yet clear.
In an inversion, a U.S.-based multinational corporation restructures (usually through a merger transaction with a non-U.S. based corporation) so that the U.S. parent is replaced by a foreign parent corporation.
The Notice relies on existing statutory grants of authority under relatively open ended “anti-avoidance” provisions currently contained in the Internal Revenue Code. It is unclear whether a plausible case can be made that some aspects of the Notice exceed Treasury’s authority under these grants. The Notice seems carefully drafted to avoid any challenge that the new rules apply on a retroactive basis. Specifically, the new rules will apply to inversions completed after September 21, 2014, whether or not the inversion deal papers have been signed or announced prior to that date. Inversions completed earlier appear to be “grandfathered” from the new rules.
The Notice is specifically targeted at techniques used by inverted companies to structure their inversion transactions in a way that permits the foreign parent to avoid being taxed in the same manner as a U.S. corporation. Techniques in this regard may include “shrinking” the size of the U.S. target through distributions or “stuffing” the foreign acquiring corporation to increase its value. The Notice also targets techniques designed to gain tax-free access to the deferred earnings of a foreign subsidiary. This may significantly diminish the ability of inverted companies to escape U.S. taxation on “trapped cash” in their non-U.S. subsidiaries.
The Notice does not address so-called “earnings stripping” techniques such as intercompany debt issued by U.S. subsidiaries to foreign affiliates that may be used to reduce the U.S. tax base through interest expense deductions. The Notice does, however, indicate that “earnings stripping” will be addressed in future Treasury guidance.
In general, other than with respect to certain "cross-chain" stock sales involving controlled foreign corporations (CFC that may generate foreign source dividend income not subject to U.S. tax, the Notice does not impact foreign-based multinationals, but it is unclear whether the future Treasury guidance on intercompany borrowings by U.S. subsidiaries and other cross-border transactions between affiliated companies will be limited to inverted companies or will apply more broadly. The Notice may make certain U.S. targets less desirable for foreign acquirers because of the reduction in tax benefits.
Specific provisions of the Notice:
- The Notice prevents inverted companies from accessing their foreign subsidiaries’ earnings while deferring U.S. tax through “hopscotch" loans. These access “trapped cash” in foreign subsidiaries by lending such amounts to the new foreign parent. The Notice removes the benefits of hopscotch loans by treating the loans as deemed dividends to the former U.S. parent.
- The Notice prevents inverted companies from "decontrolling" their foreign subsidiaries to access their earnings tax-free by selling enough stock of their CFCs to the foreign parent to remove them from the U.S. tax net.
- The Notice eliminates the ability of the group’s new foreign parent to repatriate earnings tax free by selling the former U.S. parent’s stock to its CFC. This new rule may also apply to foreign-based multinationals that have U.S. subsidiaries that in turn own foreign subsidiaries.
- The Notice makes it more difficult for some U.S. companies to invert. After an inversion, the new foreign parent corporation generally will be treated as a U.S. corporation for tax purposes unless the inverted company’s shareholders own less than 80% of the foreign parent’s stock (“80% identity of shareholders test”). The Notice prevents the U.S. company from distributing assets to reduce its value and enable it to satisfy the 80% identity of shareholders test. The Notice prevents a U.S. company from inverting a portion of its operations by transferring assets to a new foreign corporation and then distributing the new foreign corporation to its shareholders. The Notice disregards certain passive assets that a foreign merger partner does not use in a business in calculating the foreign parent’s value for purposes of the 80% identity of shareholders test.
The new provisons are very complex. To understand how they may impact you, please feel free to contact any of the authors of this alert or the Hogan Lovells lawyer with whom you have a relationship.